WASHINGTON (Reuters) - Some traders are manipulating U.S. stocks that are worth less than $1 by taking both sides of trades in order to earn big rebates, according to an official at Knight Capital Group Inc (KCG.N).

Knight, a top U.S. market maker for individual investors, and the other four largest market makers discussed this problem with federal securities regulators on Thursday, Jamil Nazarali, Knight's global head of electronic trading, told reporters on Friday.

"It happens for hundreds of millions of shares per day," Nazarali said, adding that this type of market manipulation is hard to prove. The gaming costs Knight "tens of thousands of dollars" per day on some days, he said on the sidelines of a Security Traders Association conference here.

Nazarali added that U.S. Securities and Exchange Commission officials "seemed empathetic" to the concerns of the five firms that execute much of the orders of individual, or retail, investors -- Knight, UBS AG (UBS.N), Citadel Investment Group, Citigroup Inc (C.N), and E*Trade Financial Corp (ETFC.O).

SEC spokesman John Heine neither confirmed nor denied the meeting. He did not comment on gaming in sub-dollar stocks.

The manipulation concerns come months after the May "flash crash" stoked a debate over fairness in the mostly electronic marketplace, which has grown faster and increasingly complicated in the last decade.

At issue is whether an individual trader is using separate brokerage accounts to trade against himself, something known as a wash trade. Shares that regularly trade below $1, such as Sirius XM Radio Inc (SIRI.O) and Level 3 Communications Inc (LVLT.O), are the typical targets, Nazarali said.

Exchanges charge fees to those that execute against standing buy and sell orders, something called a take fee, and pay rebates to those that provide standing orders that are executed against. This is known as "maker-taker" pricing.

While stocks are normally priced in penny increments, rules adopted five years ago allow exchanges to price sub-dollar stocks in one-hundredth of a cent. The fees and rebates, however, are based on penny increments for all stocks, including sub-dollar stocks -- which creates a possible loophole through which traders can earn out-sized rebates.

A trader can, for example, send a "limit order" bid through one brokerage account, and a corresponding "market order" to sell that same stock in another account. After trading with himself, the trader earns the bid's rebate and pays the smaller selling fee -- which is usually fixed at retail brokers like E*Trade -- and walks away with the difference.

In this scenario, market makers such as Knight would foot much of the bill.

For a short period earlier this year, large exchanges paid outsized fees and rebates in sub-$1 stocks, but did away with it in the spring after protests from market makers, said William Karsh, chief operating officer at exchange operator Direct Edge.

The smaller CBOE Stock Exchange, or CBSX, offers the out-sized rebates now. The exchange, run by Chicago-based CBOE Holdings Inc (CBOE.O), has seen its market share rise in sub-dollar stocks this summer.

"CBOE takes its regulatory responsibility very seriously and does investigate unusual trading activity," a CBOE spokeswoman said. "However we do not comment on individual investigations."

Nazarali said Knight has reported this activity to regulators on a daily bases in recent weeks, and has brought it to the attention of the Financial Industry Regulatory Authority.

"It is really damaging to investors," Nazarali told reporters.

The SEC in recent weeks said it is probing trading and quoting activity for evidence of market fraud and manipulation. In a comprehensive paper issued in January, the agency asked whether pricing in the market is problematic.

(Reporting by Jonathan Spicer, editing by Martin Golan)

The only thing surprising about this story is that Knight Capital actually broke "Omerta" and is about to eat one of its own.